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SEC’s Investor Advisory Committee takes on FASB

At Thursday’s meeting of the SEC’s Investor Advisory Committee, the Committee approved the submission of a comment letter urging FASB to reconsider its proposal to make changes to the concept of “materiality” embodied in FASB’s Conceptual Framework for Financial Reporting and FASB’s guidance on Notes to Financial Statements. See this PubCo post.

You might recall that in September of last year, FASB issued two exposure drafts as part of its disclosure framework project intended to “clarify the concept of materiality.” The exposure draft containing amendments to FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting, would modify the current definition of “materiality” to add a statement that materiality is a legal concept. The proposed amendments also included a brief summary of SCOTUS’s definition of “materiality,” based on TSC Industries v. Northway and Basic v. Levinson, in the securities law context: generally, “information is material if there is a substantial likelihood that the omitted or misstated item would have been viewed by a reasonable resource provider as having significantly altered the total mix of information. Consequently, [FASB] cannot specify or advise specifying a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.” The proposed Accounting Standards Update (ASU), Notes to Financial Statements (Topic 235): Assessing Whether Disclosures Are Material, was “intended to promote the appropriate use of discretion by organizations when deciding which disclosures should be considered material in their particular circumstances.” A key objective was to improve the effectiveness of financial statement notes by assisting companies to omit immaterial information and focus communication on material, relevant information. The amendments would apply only in the context of disclosure requirements, not to other substantive aspects of the Accounting Standards Codification (ASC).

The Committee’s comment letter contends that the proposed changes are not clarifications, but rather represent “a significant and substantive alteration to the current definition. The approach taken in the Proposals is explicitly designed to reduce disclosure and in doing so has the potential to adversely affect the quality of financial disclosure.” In addition, it maintains, FASB did not sufficiently take into account that reference to the legal definition of “materiality” would necessarily draw legal counsel into the decision-making: “[b]eyond costs, the risk exists that, by replacing the current, differentiated professional accounting standard with a case-law driven legal standard, close questions of judgment will ultimately devolve to lawyers rather than accountants.” Moreover, the legal definition, the letter argues, “has arisen in the context of the antifraud provisions under the federal securities laws. We believe that the existing terminology used by the FASB provides a better framework for determining the content of financial disclosure.”

With regard to the proposed changes to “materiality” for purposes of the financial statement notes, the letter takes issue with the basic intent to promote the increased use of discretion. According to the letter, the FASB proposal “would change the ‘default’ approach with respect to the application of materiality to disclosures in the financial statement notes. Currently, U.S. GAAP states that ‘the provisions of the [ASC] need not be applied to immaterial items.’ The formulation assumes disclosure absent an affirmative finding of immateriality. The Proposal would reverse this approach and instead provide ‘that an entity shall provide required disclosures if they are material’…. Non-disclosure would, therefore, be presumed absent an affirmative finding of materiality. This is a significant change, and one that is fraught with risk from an investor perspective.” In addition, the letter contends, while promoting an increase in the use of discretion “will no doubt be used to eliminate irrelevant disclosures,” this latitude “is fraught with the risk that disclosures that are unfavorable to the issuer are disproportionately viewed as immaterial and as a result excluded from the financial statements. Such a result is not in the best interest of investors, and is anathema to investor protection, capital formation, and the efficient functioning of the capital markets.”

The letter recommends that FASB maintain the current definition of materiality or withdraw the proposals. Failing that, the letter recommends that the “Notes” proposal return to the prior default position, i.e., that disclosures be required unless immaterial and that FASB “develop a framework for evaluating the materiality of disclosure, especially qualitative disclosures, and actively monitor the application [of] such a framework on the quality of disclosure to investors.”

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